The importance of strong cash flow

Cashflow, or the ability of a business to generate cash, is one of the most important factors for success in business. With interest rates at rock bottom levels, access to cheap capital has rarely been more available, but successfully deploying that capital to generate cash is the real measure of a business’s success.

A company’s profit margin is its ability to generate cash above that which it is spending. If a business spends £100 million and at the end of the year has £110 million, it has a profit margin of £10 million, or 10%. Once it pays tax on that £10 million, it might have £7 million left, which can then be deployed in the business to invest in research and development or new facilities, upgrade capital equipment, increase marketing and sales efforts to create new relationships, or to reward and motivate staff.

Cash is often referred to as the ‘lifeblood’ of business, without which a company cannot function. A healthy business is one in which a profit margin grows over time, reflecting greater efficiencies (many businesses require an intensive injection of capital to get started, which reduces over time, increasing a company’s profit margin).

In the construction sector, projects often cost tens, if not hundreds of millions of pounds, but margins are as slim as 1-3%, sometimes even less. Top-line revenue growth in this capital-intensive industry often leads to falling margins, as new contracts hoover up capital, often without return for years at a time. As small and mid-sized companies explore new markets, payment dates on invoices can be stretched as clients see opportunity to strong-arm newer entrants and bolster their own balance sheets.

Indeed, many construction companies operate in periods of negative cash flow, burning through capital to pay for construction materials and salaries without being paid in turn by their clients. Many clients hold retentions until the end of the project (which can be years in the undertaking) and only pay invoices 30-60 days after an invoice is submitted (which is often at the end of the month, despite the company paying salaries on a weekly or fortnightly basis). In practice, this means that a construction company could have paid our seven or eight weeks of salaries before receiving an invoice to cover them.

Improving cash flow

Obviously, this isn’t an ideal situation for construction companies, but they’re far from being alone in their situation. Thousands of companies around world struggle with cash flow, reducing their attractiveness to investors and making life difficult for their owners, employees and suppliers.

To improve cash flow, a company should first ascertain how their accounts are currently performing. When are expenses and incomes expected over the next 30, 60, and 90 days? Once this is calculated, they can begin to see where they are likely to hit shortfalls and take required steps to minimise or eliminate negative cash flow.

Keeping a tight control on costs is important for any business, but the larger the budget, the bigger the potential savings. Many smaller local suppliers are willing to cut deals to guarantee large orders, especially if they see the company as a repeat buyer. Likewise, renegotiating prices with long-standing suppliers can often help to reduce costs, as some suppliers automatically price in price rises on the basis that “they’ve always done business with us”.

Automating the invoicing system can also improve cash flow, reducing the likelihood of rejected claims and delayed invoices. The sooner a business can get a claim out the door, the quicker it will be paid. Likewise, set up a strong accounts receivable team that keep on top of invoices and act as soon as possible if invoices are not paid with deadlines. This team should also be responsible for monitoring credit worthiness, writing clear terms of payment, and restructuring terms with non-payers (after all, it’s better to receive 90p on the pound than to get 95p but to lose half of it in legal costs).

Conclusion

Together, these measures can help to improve unhealthy cash flow, but without constant management and control, the situation can deteriorate again over time. Any executive team that focuses on cash flow is an executive team I want to invest with. Admittedly, this comes with the caveat of not being at the expense of things like quality, customer service and environmental and social impact (if my investments destroy the planet and society, then they aren’t going to be much use to me!).

In the short-term, tactical changes offer significant opportunities to address cash flow inefficiencies. Better communication about the importance of cash flow, and system and process changes can result in increased free cash flow (which on a £100 million turnover company could be millions of pounds to reinvest), increased revenue (due to reinvesting that cash) and less cash tied up in working capital.
Whether looking to fund growth, protect against economic headwinds or increase shareholder returns, business strategies that optimise free cash flow play a critical role in long-term performance. The returns on cash flow improvements can be immense, reinforcing the importance of strong cash flow.